United States: California Holds First Auction Of Cap-And-Trade Program Allowances Under Cloud Of Litigation

Last Updated: November 21 2012
Article by Kevin Poloncarz, Michael S. Balster and Ben Carrier

A year after adopting its Cap-and-Trade Regulation, the California Air Resources Board (CARB) held its first auction of greenhouse gas (GHG) emission allowances today, November 14, 2012. While the results of the auction will not be available to the public until Monday, November 19, all indications are that the auction proceeded smoothly without any unexpected difficulties.

However, the auction occurred less than 24 hours after a lawsuit was filed by the California Chamber of Commerce, challenging the authority of CARB to hold an auction for allowances that allegedly should have been freely given to covered industries. Further, this is only the first of several anticipated challenges to the cap-and-trade program. This litigation may have exerted significant downward pressure on allowance prices. Thus, the price revealed on Monday, when CARB announces the auction results, may be more indicative of views on whether the program will survive legal scrutiny, than the actual abatement costs needed to achieve California's GHG reduction goals.

Background

In September 2006, Assembly Bill (AB) 32, The Global Warming Solutions Act of 2006, was signed into law, requiring California to reduce its GHG emissions to 1990 levels by 2020. The centerpiece of California's efforts to reduce GHG emissions is the Cap-and-Trade Regulation, which establishes a declining cap on approximately 85 percent of total statewide GHG emissions and is expected to account for 18% of the total GHG emission reductions needed to satisfy AB 32's mandate. Under the Regulation, entities subject to the cap (cover entities) must surrender to CARB compliance instruments equivalent to their GHG emissions. Compliance instruments include both emission allowances, which are allocated by CARB or obtained from auctions or the secondary market, and offset credits, which represent GHG emissions reductions achieved in sectors that are not subject to the cap.

November 2012 Auction

The November 14th auction actually consisted of two auctions: there were 23,126,110 current (vintage 2013) allowances and 39,450,000 future (vintage 2015) allowances available for purchase in multiples of 1,000 GHG allowances. Auction participants were able to submit bids manually and upload bid schedules at the electronic Auction Platform during the three-hour bidding window (10:00 AM PST to 1:00 PM PST). The entity with the highest bid will be allocated its requested quantity of allowances first, followed by the second highest bidder, and so on, until all of the allowances are allocated. The successful bidders will all receive the quantity of emission allowances for which they bid at the same price (i.e., the value of the lowest successful bid). If the auction is undersubscribed, then all bidders will pay the reserve price ($10/allowance).

Current Vintage Allowances

While a relatively small number of current vintage allowances in the November 2012 auction were contributed by CARB directly, the vast majority of current vintage allowances were contributed by investor-owned utilities (IOUs) and publicly-owned utilities (POUs), which must consign the allowances "freely" given to them to CARB for auction on their behalf. (The POUs can designate some share in advance to keep for their own generating resources.) The proceeds, which will be returned directly to the utilities by the auction financial administrator, must be used for the benefit of ratepayers in accordance with the direction of, in the case of the POUs, their respective governing boards and, for the IOUs, the California Public Utilities Commission (CPUC). Additionally, the CPUC's ongoing Rulemaking No. 11-03-012 will prescribe how IOUs must use their consigned allowance revenue for ratepayer relief (e.g., direct rebates). The recently enacted SB 1018 also further limits how the IOUs' auction proceeds can be used by requiring that (1) no more than 15% of consigned IOU allowance revenue be used for clean energy and energy efficiency programs, and (2) the balance be "credited directly to the residential, small business, and emissions-intensive trade-exposed retail customers."

Future Vintage Allowances

Unlike current vintage allowances, CARB provided all of the future vintage allowances available at the November 14th auction. As noted by the Legislative Analyst's Office (LAO), all the proceeds from the sale of CARB's allowances must be used for GHG mitigation projects in order to avoid problems associated with Proposition 13 (see California Constitution, Article XIII A, § 3), which requires two-thirds of the Legislature to approve any changes in state taxes enacted for the purpose of increasing revenues. Additionally, AB 1532 further directs CARB's use of auction revenues for GHG mitigation projects. In particular, AB 1532 specifies criteria for spending auction revenues and identifies a list of project types eligible to receive funding from auction revenues. Beginning with the 2013-2014 fiscal year budget, AB 1532 requires the Department of Finance, in consultation with CARB and other agencies, to develop an auction revenue investment plan consistent with the bill's spending and project eligibility criteria. SB 535, a companion bill to AB 1532, requires that the investment plan allocate at least 25% of the auction revenues to fund projects that benefit disadvantaged communities and at least 10% to fund projects located within disadvantaged communities.

The LAO estimates that CARB's revenue from allowance auctions, which will be held quarterly after today's auction, will be in the range of $650 million to $3 billion in 2012-2013. All proceeds from CARB's auction of allowances will be deposited in a new Greenhouse Gas Reduction Account within CARB's Air Pollution Control Fund until the revenue is appropriated in accordance with the Department of Finance investment plan.

Pending Threats and Legal Challenges

How these auction proceeds will be spent and, more specifically, CARB's implementation of an auction to raise such funds is already subject to a legal challenge.

Just yesterday (November 13, 2012) the California Chamber of Commerce (Chamber) filed a lawsuit challenging CARB's authority to auction allowances. California Chamber of Commerce v. California Air Resources Board, Cal. Super. Ct., No. 34-2012-80001313. The lawsuit argues that AB 32 did not authorize CARB to conduct auctions in which it would be a participant, "keep[ing] for itself a percentage of the statewide GHG emissions allowances and then sell[ing] them to raise billions of dollars of revenue for the state." According to the Chamber, when CARB allocated to itself some portion of the GHG allowances, covered entities receiving a free allocation took a so-called "haircut" from the amount of allowances they should have been awarded for free. Alternatively, the Chamber argues that, if AB 32 did authorize CARB to auction allowances to produce revenue for state coffers, then CARB's self-allocation of allowances would violate Proposition 13 as an unconstitutional tax (i.e., AB 32 was not approved by two-thirds of the Legislature, which is required for state tax increases).

Although the lawsuit did not seek injunctive relief to forestall today's auction of allowances, its filing on the eve of the first auction, as well as its central claim that CARB lacked the authority to implement an auction in the first place, seem designed to unnerve auction participants. Other, potentially more threatening lawsuits are expected to be filed against the Regulation. Regardless of their merit, such lawsuits may have dampened auction participation and exerted downward pressure on the clearing price. With four more auctions for 2013 allowances scheduled next year, market participants should not rely too heavily on this auction's result to project their compliance costs during the first compliance period. Nor should they look to the results of the future auction of vintage 2015 allowances as indicative of their anticipated compliance costs during future periods, should CARB's program withstand legal scrutiny.

Conclusion

CARB will post the settlement price and auction results for the November 14th auction on its website at 12:00 pm PST on November 19 and will inform the bidders of the auction results (i.e., settlement price and the number of GHG allowances that have been awarded). Regardless of the outcome of the California Chamber of Commerce case or any other lawsuit challenging the Regulation, the uncertainty created by such legal challenges can be expected to have some impact on the auction clearing price. As a consequence, the price announced next Monday may better reflect the market's views on whether the program will withstand legal challenge, than the actual abatement costs needed to achieve AB 32's goals.

The content of this article does not constitute legal advice and should not be relied on in that way. Specific advice should be sought about your specific circumstances.

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